Ravenglass plc: which discount rate for a new sector?
Ravenglass plc has 40 million ordinary shares quoted at $3.20 and $60 million nominal of 7% irredeemable bonds quoted at $92 per $100. The risk-free rate is 4%, the market risk premium is 5.5% and Ravenglass's equity beta is 1.25. Corporate tax is 25%. The board is appraising a diversification into a new sector, to be financed in the same proportions as existing capital, where quoted specialists have an average asset beta of 0.85. The finance director proposes discounting the new sector's cash flows at Ravenglass's existing WACC because it is 'the company's cost of capital'. A dividend growth calculation, using the 18 cents just paid, expected growth of 6% and the current share price, gives a cost of equity of 11.96%.
1. Calculate an appropriate discount rate for the new sector and explain why it differs from the existing WACC.
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Regear the sector asset beta to Ravenglass's capital structure
- Debt/equity at market value = 55.2/128 = 0.431
- Equity beta = 0.85 x [1 + (1 - 0.25) x 0.431] = 0.85 x 1.323 = 1.125
Project cost of equity Ke = 4% + 1.125 x 5.5% = 10.19%
Project WACC (same financing mix as the group, so the same weights and after-tax Kd) = 0.6987 x 10.19% + 0.3013 x 5.707% = 7.119% + 1.720% = 8.84%
Why it differs Ravenglass's 9.32% embeds an asset beta of about 1.25 (its equity beta, since its gearing is modest). The new sector's underlying business risk is captured by an asset beta of 0.85, so the project's shareholders require a lower return. The 0.48 percentage point difference is not trivial over a ten-year project.
Why it matters Using 9.32% for a lower-risk project understates its NPV and could lead the board to reject a value-creating diversification; applying 9.32% to a genuinely riskier project would overstate NPV and destroy shareholder value. A single group WACC is only valid for projects with the group's average risk.
Caveat The regearing assumes the project is financed in the existing proportions and that the debt beta is zero. If the board intends to fund the project with project-specific debt, the weights must be reset to the target structure and the beta regeared again.
2. The board asks which cost of equity to use, the CAPM figure of 10.875% or the dividend growth figure of 11.96%. Advise.
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What each model is measuring
- CAPM (10.875%) prices systematic risk explicitly and, crucially, can be re-run with a different beta for a different business. That is exactly what the diversification decision requires.
- Dividend growth (11.96%) is derived from the current share price: 0.18 x 1.06/3.20 + 0.06 = 5.96% + 6.00%. That price reflects the market's view of Ravenglass's existing business mix, so the figure is backward-looking for a new sector.
Weaknesses to weigh
- The DGM depends on a constant 6% growth rate forever, which for a cyclical engineering business is a strong assumption; a 1% change in g moves Ke to roughly 10.9%, so the estimate is highly sensitive.
- CAPM depends on a beta estimated from historical share prices, on the choice of market premium and on a risk-free rate that is itself contested; it also assumes a well-diversified marginal investor.
Advice Use the CAPM-based figures for appraisal, because only CAPM can be adjusted for the project's risk. Use 10.19% for the new sector, supported by the group figure of 10.875% and by the DGM result as a sanity check on the general level of the cost of equity. Since the three estimates sit within roughly 1.8 percentage points of each other, run the project NPV at 8.84%, 9.32% and 11.96% and report the range. If the project is marginal across that range, the decision should rest on strategic grounds rather than on a single point estimate of the discount rate.